XEROX FRAUD CASE

Barry D. Romeril was Xerox’s chief financial officer (CFO) since 1993 and was credited,
along with then chairman and chief executive, Paul Allaire, of leading Xerox through a
difficult period in the late 1990’s. During this time Xerox was faced with stiff
competition from foreign markets while losing a considerable portion of their core small
copier business to desktop printers. Also a new internal reorganization had been poorly
implemented, putting salespeople in unfamiliar territory and tying the billing department
up in knots. During this period, Xerox also lost millions of dollars on their
diversification effort into insurance and financial services.

Yet, through all of this, Mr. Allaire and Mr. Romeril seemingly managed to keep Xerox
headed in the right direction, and meeting Wall Street earnings expectations every
quarter, keeping stock prices rising and investors happy.

However, Allaire’s prediction of an impending crisis turned out to be truer than most
people would have expected. Unknown to outsiders, Xerox top executives had adopted
an attitude of win at any cost and they turned to their accounting department to help them
do this. By the mid-1990s Xerox management had decided they were going to have their
accountants come up with some pretty creative accounting if they were going to be able
to keep showing Wall Street and their stockholders that they were still able to meet their
earnings expectations.

SEC Investigation

For Xerox it all started to publicly unravel in May 2000, when Xerox made its first public
announcement that they had discovered accounting irregularities associated with its
Xerox-Mexico operations. As the problems at Xerox-Mexico became public, in June of
2000 the Securities and Exchange Commission (SEC) launched an investigation into
what was happening at the Xerox-Mexico subsidiary. At the same time Xerox’s audit
committee hired the Washington DC law firm of Akin, Gump, Strauss, Hauer, & Feld to
conduct an independent investigation about what was happening at the Mexican
subsidiary with explicit instructions to limit the scope of their investigation to the Mexico
division. When the law firm found indications that aggressive accounting practices may
have been used in other areas, they were told by internal Xerox lawyers to stick with
Mexico only and that Xerox management, including CFO Mr. Romeril, would look into
accounting issues outside of Mexico.

In February 2001, with the SEC starting to look beyond the Mexican unit, in an effort to
reassure company investors, Mr. Allaire presented the conclusions of the Akin, Gump
investigation. He announced that some of the problems found during the investigation in
Mexico included failures to write off their mounting bad debts and improper
classification of transactions. Mr. Allaire went out of his way to distance corporate
executives from the problems in Mexico by blaming a small group of Xerox Mexico and
Latin American executives, accusing them of acting in collusion to circumvent company
policies and procedures. As a result of the investigation, 13 managers were fired or
removed and Xerox had to write-off $120 million in 2000.

Shortly after Xerox released the results of the Akin, Gump report, Xerox also released
results of the internal world-wide investigation. For the first time, Xerox said that some
of the problems went beyond Mexico, forcing it to increase reserves in some smaller
Latin American countries, while at the same time suggesting there were no accounting
issues found in any other major units. Following closely, Mr. Romeril also publicly
announced for the first time that the SEC had widened its investigation beyond Mexico.

Xerox executives frequently assigned accountants numerical goals to produce profits

through accounting actions. It just became standard operating procedure to look to the
accountants to find income. Xerox’s underlying business was deteriorating and no one
was doing anything to try to fix it except using accounting trickery.

Xerox had some criticisms of the change in booking for services and supplies as part of
the company’s leasing agreements, but the bigger concern was how the company was
making overly inflated assumptions about the value of future leases in developing
countries. Xerox would rapidly reduce the discount rate too far below the local interest
rate, allowing them to book more revenue. While this doesn’t fabricate revenue, it shifts
revenue to current period from future periods. Xerox was using the lower rates because
there was no other way that the managers in developing markets were going to meet their
revenue goals for 2000. Xerox had improperly booked $447 million in pretax income
over the previous six years using the understated discount-rate assumptions when
booking leases, primarily in Latin America.

The SEC investigation and review by KPMG, the auditors, revealed internal memos in
which senior Xerox management actually discussed accounting practices that could be
used to increase earnings in line with Wall Street expectations. While Xerox officials
dismissed this as simple “brainstorming” that was encouraged at Xerox, KPMG insisted
that fake transactions and illegal revenue recognition should never be discussed and
refused to sign the 2000 annual report despite threats from Mr. Allaire that this could lead
to bankruptcy.

Findings
The SEC findings after investigation found that from 1997 through 2000, Xerox "pumped
up its earnings by nearly $500 million through the release into income of excess or
`cushion' reserves originally established for some other purpose," and Xerox committed a
worse violation under the rubric of another earnings-management favorite: revenue
recognition. The company improperly sped up the recognition of equipment revenue by
over $3 billion, according to the commission. In the end, the SEC extracted a $10 million
fine and three years of restated results from Xerox — but no admission of guilt.

Interestingly, observers say that such high- profile SEC investigations seem to be
dampening executives' enthusiasm for over-the-top earnings management. So, too, have
various rule changes promulgated by the Financial Accounting Standards Board. In
addition, Standard & Poor's new "core earnings" metric could also make it harder for
companies to set up phony reserves.